Validea's Guru Investor Blog

A decade of historically low interest rates has encouraged businesses to increase leverage and this could prove dicey for investors, says a recent Barron’s article.

According to Morningstar fund analyst Kevin McDevitt, companies have been refinancing or borrowing for share buybacks, not necessarily to invest in existing businesses. “The leverage,” he says, “is an added risk not only to the individual companies, but also to the funds that own them.” Morningstar research found that, in the wake of the 2008 crisis, funds with high debt/capital ratios “dramatically underperformed low debt/capital ones and the market, losing about half their value, while the Standard & Poor’s 500 index fell 37%.”

Jayme Wiggins of the Intrepid Endurance fund points out that stretched valuations add a layer of risk into the mix. “If you’re borrowing to buy back stock and the stock is cheap and you’re keeping your leverage reasonable, that’s fine.” However, he says, the median company in the Russell 2000 is currently trading at a multiple of 30, twice the level at which he is comfortable.

The article argues that investors should “look under the hood” of fund portfolios, even those that invest in high-quality companies with strong brands and stable cash flow. McDevitt asserts, “The way many investors define quality today is by competitive advantage. Leverage is a separate discussion for them. But if you lever any business up, you suddenly have a lot of risk.”